FOREX EDUCATION: Everything You Need To Know About Forex Trading
Below are the main theories that determine the exchange rates between the currencies.
Supply and Demand
The price of the currency responds to the forces of supply and demand. The general rule is if some people increased their demand for a specific currency, then the price will rise provided the supply remains stable. On the contrary, if the supply is increased, the price will decline provided the demand remains stable.
Purchasing Power Parity
The Purchasing Power Parity or PPP is based on the “Law of One Price”. This law is based on the assumption that identical goods are sold at equal prices. To put it simply, using a unit of currency can purchase the same goods at home and abroad.
This theory argues that should a Euro price of a good be multiplied by the exchange rate (€ /US$) then it will result in an equal price of the good in US dollars. For example, if the exchange rate between the € and US$ is at 1/1.2, then goods that cost € 10 in Europe should cost US$ 12 in the United States. Otherwise, arbitrage profits will occur.
The PPP approach continues to be applied until now. This approach lays down the fact that exchange rate has to compensate for the difference in inflation rate. But this approach is not a good value of money because first of all not all goods are traded internationally like buildings for example. Furthermore, the transportation cost should represent a small amount of the good's worth. For some, the PPP approach is also not a very reliable determinant because changes in technology, commercial policies and labor force can change the real exchange rate.
Balance of Payments Approach
The Balance of Payments approach or BOP for short explains what the factors are that determine the supply and demand curves of a country's currency. The balance of payments records all the international monetary transactions of a country during a specific period of time. The transactions recorded are the current account transactions, the capital account transactions and the central bank transactions. All three transactions can either be a deficit or a surplus but theoretically the overall payments or the BOP as a whole should be zero, but this rarely happens.
As a general rule, the appreciation and depreciation of a currency directly affects the volume of a country's imports and exports. For example, a likely depreciation will increase the value of exports in home currency terms. Conversely, the imports will become more expensive and their value will be reduced in home currency. Unless the value of exports increases less than the value of imports, the depreciation will improve the current account. More specifically, we can finally assess the impact of the currency's depreciation on the current account only by considering the price sensitivity of imports and exports.
The Monetary Approach
The Monetary Approach believes that the exchange rates adjust to ensure that the quantity of money in each currency supplied is equal to the quantity demanded. In this approach the focus is on the stock of currencies rather than the willingness of people to hold these stocks.
It is therefore safe to say that an increase in the money supply of the home currency will lead to inflation. This in turn will decrease the purchasing power, resulting to the depreciation of the currency's exchange rate. Moreover, rising interest rate will also lead to the currency's depreciation because of the positive relationship between interest rates and money circulation. Lastly, if the GDP rises faster than overseas GDP, the demand for money will increase. Assuming there is a given supply of money, the exchanged rate will decrease, which is in direct contrast to the PPP approach.
Portfolio Balance Approach
The Portfolio Balance Approach considers the diversification of investors' portfolio assets. It simply states that an increase in the money supply will lead to a depreciation of the exchange rate. For example, if domestic money supply increases, we should expect for a lower interest rate or a higher exchange rate to absorb the excess supply, which in turn will result in the reduction of bonds.
Interest Rate Parity
Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in one currency, exchanging that currency for another currency and investing in interest-bearing instruments of the second currency, while simultaneously purchasing futures contracts to convert the currency back at the end of the holding period, should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency. If the returns are different, an arbitrage transaction could, in theory, produce a risk-free return.